IRS Revenue Ruling 2008-31 Says Property Derivatives Contract on US Real Property Index Not Interest in Real Property Under Tax Code

According to the IRS, a property derivatives contract is not considered real property for purposes of the federal tax code. Revenue Ruling 2008-31 declares that a foreign company’s interest in a notional principal contract the return on which is calculated by reference to an index referencing data from a broad range of United States real estate is not a real property interest under section 897(c)(1) of the Internal Revenue Code.

Because of the broad-based nature of the real property index, reasoned the IRS, an investor cannot, as a practical matter, own or lease a material percentage of the real estate, the values of which are reflected by the index. The foreign company entered into the derivatives contract with an unrelated counterparty, a domestic company. The foreign company profits if the Index appreciates to the extent the underlying United States real property in the particular geographic region appreciates in value over certain levels.

Conversely, a loss is suffered if the Index depreciates or fails to appreciate more than at a specified rate. During the term of the derivatives contract, the counterparty does not, directly or indirectly, own or lease a material percentage of the real property, the values of which are reflected by the Index.

Section 897(a) provides that gain or loss from the disposition of a US real estate property interest of a foreign company or individual must be taken into account as effectively connected income under section 871(b)(1) or section 882(a)(1), respectively, as if the taxpayer were engaged in a trade or business within the United States during the taxable year and as if such gain or loss were effectively connected with such trade or business.

IRS regulations adopted under Section 897 provide that an interest in real
property includes any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.
Because of the broad-based nature of the index, the derivatives contract does not represent a direct or indirect right to share in the appreciation in the value … of the real property within the meaning of the regulations. Thus, the IRS concluded that the foreign company’s interest in the derivatives contract calculated by reference to the index is not a US real property interest under section 897(c)(1).